September 25, 2008

Johnson School Panel Discusses Wall Street Crash

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“Expediency is not a good guide for policy, and that is where we are right now,” said Prof. Maureen O’Hara, the Robert W. Purcell Professor of Management in the Johnson School of Management.
As Congress continues to debate Bush’s proposed $700 billion economic recovery plan, last night a panel of professors from the Johnson School analyzed the causes of the financial crisis and offered solutions for the future. Over 250 people attended the discussion.
Moderated by Prof. Doug Stayman, marketing, and the associate dean for curriculum at the Johnson School, the Market Crisis Panel addressed the tumultuous events in the finance world that have happened over the past days.
“I think we all know why we’re here,” Stayman said. [img_assist|nid=32091|title=Crisis in review|desc=Students listen as a panel of Johnson School of Management faculty members discuss the current credit crisis at Sage Hall yesterday. The panel attracted 250 attendees.|link=node|align=left|width=|height=0]
Organized in under a week, the panel featured three professors from the Johnson School including Prof. Robert A. Jarrow, finance and economics and the Ronald P. and Susan E. Lynch Professor of Investment Management, Richard Marin, a visiting senior lecturer and the Johnson’s executive-in-residence in asset management professor as well as O’Hara.
“This is sort of an atypical event for us,” said Roger Marin, events coordinator for the Johnson School.
Jarrow, an expert in risk management, began the panel by citing two factors, which combined with misaligned incentives, led to the financial crisis.
First, he said that subprime loans are complex derivative securities. Subprime loans are loans given to individuals who do not qualify for prime rate loans, often as a result of bad credit. Subprime loans are more risky than regular loans because they are less likely to be paid back.
Second, ratings agencies incorrectly rated the loans for many reasons such as inaccurate historical data, which does not represent the current subprime pool.
He also said that high housing prices and low interest rates led to inaccurate ratings.
“The problem is the assets you have aren’t good ones,” he said.
O’Hara, who focuses on market microstructure in her research, asserted that even though the Federal Reserve has pumped tons of money into the economy to “shore up” the markets, banks are still reluctant to give out loans because they are worried they will not be paid back.
“Liquidity depends on confidence. Once that is lost, everyone goes to their safest point,” she said. This has important implications for the international market as well because foreign investors are less likely to have faith in the U.S. market.
Liquidity refers to the extent to which an asset can be bought or sold in the market without affecting its price.
Both O’Hara and Marin contended that the bailout is the right plan of action at this time.
“The market has to be convinced that the problem can be solved. The Treasury bailout is the right idea,” O’Hara said. “The banking system and the financial market are widely viewed as having lost track partly due to the regulatory system. The [current] regulatory system is for banks, not markets. No matter how you look at it, you have to regulate.”
She described a good market as one that can provide liquidity that does not need to come from a central bank.
In a written statement passed around at the event, Marin, who served as chief executive of Bear Stearns Asset Management when it started to collapse late last year, said, “Wall Street as we have known it is dead.”
There has been much debate across the nation about whether the government should bail out Wall Street with taxpayers’ money or whether Wall Street should be left to deal with its own follies. However, Marin was quick to point out that the broken parts of Wall Street affect everyone.
Marin explained why mainstream Americans should care about the collapse of the market. First, capital markets are frozen up. Then, trading activity is stalled because people are afraid to take risks. Finally, the prime-brokerage business — the main business of the big five investment banks including Goldman Sachs and Morgan Stanley — has lost 25 percent of their revenue streams. Prime brokerage refers to the variety of financial services that investment banks offer to clients and hedge funds.
This combination leads to unstable housing prices.
“Until you have a bottom on housing prices, you can’t stabilize the market,” he said. “Without Wall Street, you can’t have mortgage finance.”
During the question-and-answer period, one audience member asked whether any of the proposed plans to solve the crisis would alleviate the mortgage default. The panelists, however, did not give a clear answer.
Another asked what the implications were for mainstream Americans and whether they were partially at fault for the crisis for taking out risky loans.
Jarrow answered that people were overextended and had taken out too many loans, but that it was the conditions that had made it too easy to do so. O’Hara similarly admitted that while some people took out loans knowing they could not pay them back, others were issued loans that they should not have been, suggesting a regulatory failure.
Though Morgan Stanley and Goldman Sachs have become commercial banks as of this week, ultimately, Marin suggested in his written statement that this change “is not the long-term platform that will support business effectively or motivate talent to perform at its peak.”